In January, Paul Krugman, famous for his pithy polemics and nifty models, visited Hong Kong to share his thoughts on China’s economy. As I mentioned in a previous article, his views are a little alarming. China’s growth model, he thinks, has exhausted its limits: its countryside has run out of surplus labor, and without an influx of new workers, its cities cannot sustain their high rates of investment. By flooding the economy with credit, China’s leaders have “postponed the day of reckoning,” in his words. But when capital spending finally falters, consumer spending will not grow fast enough to fill the gap in demand. The result, says Krugman, could be a “very nasty recession — maybe worse.”

Krugman is not arguing that China’s level of spending is too high. The country has little inflation and a record trade surplus, according to the National Bureau of Statistics (NBS) and the Ministry of Commerce. It is, in other words, living well within its means. The professor worries instead that its mix of spending is askew: investment is too high relative to consumption.

Krugman is hardly alone in making this kind of argument. And China is hardly the first economy to arouse such fears. The notion that investment booms turn, with grim predictability and strict proportionality, into nasty busts is deeply intuitive and perennially popular. The sequence seems both empirically plausible and ethically satisfying. It accords with a casual look at the evidence. Better than that, it accords with ingrained notions of Providence. Fast must follow feast; hubris must be punished by nemesis; haughty animal spirits goeth before a fall in GDP.

But this “hangover” theory of recessions is surprisingly hard to square with economic principles. Indeed, the theory was skewered years ago in a memorable column written by an eloquent economist, who lacked a Nobel Prize but excelled at poking holes in conventional wisdom.

Pull don’t push; remix don’t recede

Why, this economist asked, must the ups and downs of investment spending lead to ups and downs in the economy as a whole? Historically, they often do so. But why must they do so? Just because a country’s mix of spending needs to change, why must the level of spending fall? If people spend less of their income on investment goods, surely that leaves them with more to spend on consumer goods. If workers need to migrate out of capital-goods industries into sunnier consumer sectors, why must the migration be such an ordeal? Strong hiring and attractive pay can, after all, “pull” workers in to burgeoning economic sectors. It’s not necessary for wage cuts and layoffs first to “push” them out of an economy’s twilight industries.

To these questions, the columnist offered a deceptively simple answer. People sometimes decide to spend less on investment goods without deciding to spend more on anything else in particular. They instead try to build up their money holdings to keep their options open for the future. Hoarding liquidity represents a decision not to decide. And this indecision depresses production because firms do not know how to respond. They cannot hire people to make something-in-general-but-nothing-in-particular.

If this is what causes a slump, then the cure seems straightforward, the columnist pointed out. If the difficulty is an increase in the demand for money, then the central bank can fix the problem by simply printing more of it.

True, this monetary fix does not remove all pain. A shift in spending can leave behind a trail of bad investments, along with the debt raised to pay for them. But our brisk economist had an answer to that too: “Junk the bad investments and write off the bad loans.” Yes, someone will be less wealthy as a result. But there is no good reason why any worker should be less busy as a result. A write-down of national wealth need not result in a nasty contraction in the flow of national production. “[N]obody has managed to explain why bad investments in the past require the unemployment of good workers in the present,” he wrote.

As you’ve no doubt guessed, this impassioned attack on the hangover theory of recessions was written by none other than Paul Krugman, back in 1998 (before he landed his New York Times column and his Nobel Prize). The article, which appeared in Slate, left a deep impression on many readers, including those it attacked. It made a compelling case that the hangover theory was not only wrong, but harmful, discouraging the very policies that would disprove it.

And yet the causal story Krugman described and demolished back then sounds very much like the sort of thing the China bears say today. Let me quote from the article once more:

“In the beginning, an investment boom gets out of hand. Maybe … reckless bank lending drives it…. Whatever the reason, all that investment leads to the creation of too much capacity — of factories that cannot find markets, of office buildings that cannot find tenants.… Eventually, however, reality strikes — investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off … only then is the economy ready to recover.”

For those of us impressed by his 1998 column and concerned about China, the echoes are a bit disillusioning. Krugman now appears to espouse something like a hangover theory of the world’s second-biggest economy.

What accounts for this apparent inconsistency?

I can think of several likely explanations. China’s investment boom has been unusually big. Krugman may therefore put the Middle Kingdom in a category of its own, given the size of the adjustment he now thinks it needs. In addition, the younger Krugman was writing long before the global financial crisis. That 2008 calamity has forced most mainstream economists to reconsider the dangers of debt and the limits of money printing (although Krugman himself was conscious of these problems long before).

Is China unusually vulnerable to a hangover?

China’s investment boom has been larger than anyone in 1998 could possibly have imagined. In the years since, its gross capital spending has amounted to roughly $38 trillion (at 2014 prices and exchange rates, according to my calculations, based on investment prices reported by economists at the People’s Bank of China and 2014 estimates by the International Monetary Fund).

Krugman thinks China’s investment rate might now have to fall by as much as 20 percent of GDP. Such a big shift in spending would require a similarly large shift in production. Perhaps, then, China will suffer a hangover because of the sheer scale of its investment boom and the vast scope of the rebalancing it now requires. Moving workers from one industry to another is not, after all, frictionless, as hangover theorists point out.

But as I mentioned in a previous column, it is not obvious that the investment slowdown needs to be quite as big or as sudden as Krugman thinks. China’s workforce is still vast, urban employment is still growing, and its stock of accumulated capital per worker is still modest. Even though China has invested a high proportion of its GDP for many years, its GDP used to be much smaller than it is now. Thus the amounts it added to its capital stock in earlier decades do not add up to all that much compared with the size of its present-day labor force. China may have invested about $38 trillion since Krugman wrote his 1998 column, but the United States, with a workforce a fifth of the size, has invested about $50 trillion (at 2014 prices) over the same period.

China’s frictionless job market

Moreover, China’s brutally flexible labor market is subject to fewer frictions than most. Chinese workers are famous for their mind-boggling mobility. Over 168 million people (members of China’s so-called “floating population”) have left their rural roots for industrial or service jobs away from home, according to China’s National Bureau of Statistics. When export orders evaporated in late 2008, millions of workers abruptly lost their jobs in coastal factories. But, after repairing to their home villages for a few weeks or months, many found work on urban building sites instead, World Bank research shows.

Frictions cannot, in any case, be a sufficient condition for slumps, as the younger Krugman (echoing the economist Gottfried Haberler) was quick to point out. Frictions hinder movement. But capital and labor move during booms as well as busts. This churn alters an economy’s shape without shrinking its size. Thus economies can remake themselves without requiring a recession to do so. China itself is a good example. The chart below shows how China’s broad industrial mix has evolved over the past eight years of fast growth. By this (admittedly crude) comparison, China’s partly planned economy looks more protean than the dynamic United States.

China’s shape-shifting should not be surprising; it is, after all, a developing country in the midst of a profound economic coming-of-age. Nonetheless, the chart should reassure those who think that growth and restructuring are at odds with each other. China’s economy can expand, it seems to me, without all of its existing industries expanding proportionately. It can grow swiftly without growing isomorphically.

The dangers of debt

Written before China’s investment boom, Krugman’s Slate piece was also written long before the global financial crisis. The horrors of September 2008 show that it is not so easy to “junk the bad investments and write off the bad loans,” as he put it then, without fatally interrupting the flow of new credit.

When an investment turns bad, someone has to bear the loss. If the venture is equity-financed, the shareholders take the hit. If it is debt-financed, things are more complicated. The lender will try to cover the loss with the collateral it seizes and the provisions it has set aside. In principle, the lender’s shareholders bear the rest.

But the loss can be bigger than the shareholders’ entire financial stake. In that case, some of the pain may fall on the lender’s own creditors, who provide the rest of its financing. This is where things can spiral out of control. As we saw in 2008, the bank’s creditors are unlikely to sit still and take their lumps. They will instead scramble to avoid taking any losses, calling in their loans, demanding more collateral, or withdrawing their deposits. And just as they refuse to roll over their loans to the bank, they themselves may find it impossible to roll over their debts to their own wary creditors. Panic travels from one link of the credit chain to the next. In this way, a sizable, but manageable, initial loss creates a cascading liquidity crisis, which results in ever-bigger losses.

In the thick of the global financial crisis, Krugman (among others) argued forcefully for a solution: the state, with its deep pockets, should take an ownership stake in troubled financial institutions. That would restore confidence in these banks, allowing them to roll over their debts. The state would be exposed to potential losses (and possible gains), but at least those losses would not snowball. And besides, by changing its tax and borrowing plans, the state could decide which group of taxpayers, now or in the future, ultimately bore the costs.

How does all of this apply to China and its banks? The size of the banking system’s exposure to bad investments is a matter of great uncertainty and wide conjecture. (Officially, only 1.25 percent of bank loans were non-performing at the end of last year, according to the China Banking Regulatory Commission. The market, on the other hand, was pricing in an average ratio of 14.8 percent in December, across 10 of the biggest listed banks, according to calculations by Judy Zhang of BNP Paribas. The truth is probably closer to 7 percent, she reckons, an exposure that China’s banks could probably withstand, thanks to their profits and provisions.)

If bad loans did overwhelm the banks, would the Chinese state step in to nationalize them, following the advice that Krugman offered America in 2009? No need. China’s government already owns controlling stakes in the vast majority of its banks. They come pre-nationalized.

State ownership of banks has big drawbacks, of course. It can politicize lending and undermine commercial discipline. Nor does government backing magically erase the losses from bad investments. It does, however, help prevent these “primary” losses from snarling up the financial system, resulting in second- and third-round losses, as a lender’s creditors and its creditors’ creditors take fright. State ownership makes bad loans more likely, in my view, but less contagious. They become systematic but not systemic.

The limits of money printing

The financial panic that so worried Krugman in early 2009 abated later that year. But America’s semi-slump persisted. Indebted households, desperate to improve their financial position, pared their spending, thereby depressing income and employment for everyone else. America’s central bank tried Krugman’s 1998 prescription — “printing money.” But although it created an extra $1.8 trillion from August 2008 to August 2011, according to Fed statistics, it was sadly not enough to solve the problem.

The slow recovery prompted Krugman to return to the blackboard. In a 2010 academic paper with the Brown University economist Gauti Eggertsson, he tried to explain why the debts of the past resulted in the unemployment of good workers in the present.

The question he posed was similar to the one he voiced in 1998. If debtors spend less, why don’t others spend more? Debtors, after all, owe their money to someone (often a fellow countryman). So if debtors stop spending other people’s money, why don’t those other people spend it instead?

In Krugman and Eggertsson’s model, that is exactly what happens in the normal case. Debtors save more, interest rates fall, and, in response, creditors save less. The economy remains fully employed even as borrowers reduce their leverage and lenders reduce their saving. A slump only ensues in special cases. Sometimes the desire to save is unusually strong and the willingness to spend is unusually weak. In these cases, interest rates would have to fall significantly below zero to provide a sufficient spur to dissaving. In these scenarios, the economy is trapped, because nominal interest rates cannot fall as far as they must. (They cannot fall much below zero because people can always hold zero-yielding cash instead, despite the inconveniences of storing it.)

A billion at zero?

America, like Japan before it, has found itself stuck at this “zero lower bound.” But what are the chances that China, faced with a similar bout of deleveraging, would encounter the same problem? It’s not impossible. But it seems unlikely.

Most economists assume that an economy’s long-run natural interest rate bears some relationship to its growth rate. At about 8 percent, according to the NBS, China’s nominal growth rates are much slower than they were, but still much faster than those in the United States or Japan. Zero interest rates in China would therefore be considerably more stimulative than they were in those countries. Indeed, it is hard to think of any catch-up economy that has ever run up against the zero lower bound.

A “somewhat comprehensive socialization”

When bank rescues and money-printing prove insufficient, Krugman’s additional prescription for escaping a slump is, of course, bold fiscal stimulus. By spending more and taxing less, governments can revive demand and help restore monetary policy’s grip. He was thus disappointed by America’s 2009 stimulus efforts, which were too small and abandoned too soon, he argued, allowing unemployment to fester.

The same cannot be said of China’s quasi-fiscal response to the same crisis. Its sprawling network of state-owned enterprises and local-government financing vehicles spent vast sums of money created by its state-owned banks. By the end of 2010, China’s stock of bank credit exceeded its pre-crisis trend by almost 4.7 trillion yuan, according to my calculations based on Chinese central bank statistics. These efforts did not fall short. If anything, China’s stimulus was too big and abandoned too late.

In the view of many commentators, China’s stimulus is synonymous with waste and extravagance. Critics rightly complain about creative accounting, speculative land-buying, and quadruplicative bridge-building. But in complaining about this investment spree, they do not much consider what would have happened without it. Even if the stimulus did not make best use of workers’ time and energy, at least it made some use of their time and energy. Without it, these man-hours would have been lost to the economy forever. In addition, stimulus jobs gave workers wages to spend, which created less questionable employment elsewhere in the economy. The result was “micro-inefficient” but “macro-efficient,” to use terms coined by the late economist Paul Samuelson.

If growth slows sharply again, China would hope to replicate the macro-oomph of the post-crisis stimulus without the micro-waste. Beijing has, for example, tried cannier expansionary measures in response to subsequent weak spells, including tax cuts, pay hikes, and targeted investments. “We still have a host of policy instruments at our disposal,” Premier Li Keqiang reassured reporters on March 15.

Krugman is, I think, a little wary of endorsing China’s response to the last crisis, with all the clumsy spending it entailed. He is trying to make fiscal stimulus respectable in the United States. And the fact that China tried it (and it worked) would not count in the policy’s favor in America’s polarized political circles.

But one Keynesian economist, whom Krugman admires greatly, thought this kind of state-orchestration of investment rates might be uniquely effective in a slump:

“[I]t seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment; though this need not exclude all manner of compromises and of devices by which public authority will co-operate with private initiative.”

That passage is not a description of China, although it could be. China’s government still “socializes” a somewhat sizeable chunk of the country’s investment (over 30 percent according to the NBS), and makes all manner of compromises between public authority and private initiative. The words quoted above were written not in 2015 or even in 1998, but in 1936. The author, more Keynesian than Krugman, was of course John Maynard Keynes himself. Perhaps China’s economy would have scared him as much as it scares his intellectual heir. But I tend to think he would have kept his nerve.

Disclaimer: This article does not represent investment advice or any kind of professional counsel, nor does it represent an offer to buy or sell securities or investment services. The opinions, which are subject to change, are those of the author not BNY Mellon Investment Management.